Foreign Earned income exclusion for expats
What is Foreign Earned income exclusion? Form 2555
Table of contents:
What is foreign earned income Exclusion?
As a US Citizen or a Green Card holder, you are allowed to exclude up to $108,700 of foreign source income on your tax return for 2021 if you maintained a “Tax Home’’ and lived abroad. In addition to this, you can also claim the housing exclusion or deduction for the accommodation costs you incurred abroad.
Before we jump into the 2 types of tests for claiming FEIE, it’s very important to understand the definition for the “Tax Home’’.
Your tax home is your principal place of employment, business/ duty regardless of where your family home lies. If you do not have a fixed home (digital nomad/vagabond) your tax home is your regular place of abode (the place where you spend the most amount of time). The location of your abode is based on your economic/social/family ties. Your abode is not the United States, just because you maintain a family home there.
To conclude, a Tax Home refers to the jurisdiction where the taxpayer conducts this economic and business activity. Use the IRS tool here, if you are unsure.
What are the two methods to claim foreign earned income exclusion ?
The 1st method is called Bonafide Residence Test (BFR). This is a qualitative test, meaning you need to be a bona-fide( good faith) resident of that country, tax home must be in that country, place of work, bank accounts etc. must be in that country for an uninterrupted period that includes an entire tax year (January 1–December 31, if you file a calendar year return). In the initial year of departure, you will have to satisfy the above test by being a resident of that country, the following year to claim BFR. Say that your assignment starts in september 2021, for the tax year 2021, you will have to be a resident in the assignment country for the entire 2022. Your 2021 Tax return will only be filed in January of 2023! Form 2350 needs to be filed for seeking extension of time due to form 2555 – Foreign earned income exclusion. This method is usually applicable to long term assignments of the Taxpayer which usually last more than 12 months.
If your spouse is working abroad as well and has foreign earned income and meets the above criteria, would be eligible for their own separate “ earned income exclusion”. Assuming both are staying in the same foreign home, housing exclusion can be taken by the taxpayer who’s Foreign earned income is higher. The exclusion can also be considered for self-employment income as well.
The second method is called the Physical Presence Test. This is a quantitative test, where a US Citizen or a resident must live in foreign country for at least 330 days (non-consecutive) over a 365 day period. The 330 full days can be interrupted by periods when you are traveling over international waters or are otherwise not in a foreign country. Assuming a 365 day annual year, a taxpayer can be in the US for a maximum of 35 days in a year to meet the test. Also once 330 foreign days(non-consecutive) conditions are met, then any of the 35 days allowed for US days that are remaining can be rolled back from the beginning of the assignment or the ending of the assignment, thereby extending the qualifying day period,also known as “slide days”. Usually Green card holders follow the PPT method as a safe approach as Green card holders can only be a resident of one country at time! Assuming, if there is a Tax treaty from the taxpayers country of birth/origin/ citizen with the United States, non discrimination clause, if given in the tax treaty can be used to claim BFR in those instances. This is a very aggressive position which may get a scrutiny check from the IRS.
Also, the choice to claim FEIE is of the Taxpayer, on whether to claim or not to claim. Else, it may also be beneficial to go with Foreign Tax credits, if the taxpayer is on assignment to a high tax country. Once the taxpayer does decide to claim the exclusion, the taxpayer has effectively elected to claim the exclusions in all future years that the taxpayer qualifies to claim. The taxpayer can also revoke the election, however might not claim again for 5 years, unless it has special permission from the IRS. The foreign assignment country can change during the year or during the duration of claiming this exclusion. The taxpayer can have back to back assignments in Foreign country without breaking these tests.
Foreign Housing Exclusion
Along with the above mentioned tests for exclusion, the Taxpayer is also eligible for the Foreign housing exclusion or deduction (self-employed). The housing expenses do have a limit on them. For most locations, in 2021 it’s limited to 30% of the $108,700. The housing expenses limits are based on the geographical differences in the housing costs compared to the United States. Staying in Bali would have a different limit as compared to staying in London. The Housing Exclusion is addition to the Foreign Earned Income Exclusion (Over and above of $108,700). There is a table on the IRS website for the same.
Due to Covid-19, the IRS has provided waiver of time requirements globally as of Feb. 1, 2020 and in the People’s Republic of China, excluding the Special Administrative Regions of Hong Kong and Macau (China), as of Dec. 1, 2019. The period covered by the waiver of time requirements ends on July 15, 2020. If an individual who has left the foreign country on or after Feb. 1, 2020, (or China on or after Dec. 1, 2019) but on or before July 15, 2020(unless extended by the IRS) may be treated as a qualified individual during the period the individual was present in a foreign country. The individual must have either established residency or been physically present in that foreign country prior to those dates given above to be eligible. In short, all the other tests for Tax home, Foreign Earned Income exclusion still apply except for the days count.
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DISCLAIMER: The above info should only be considered for the knowledge of US Tax. Every Taxpayers situation is unique, strongly advice you to consult a Tax Professional.